Permanent Zero: Record Low Treasury Yields and Banking Instability

The Fed is squeezing interest rates down to levels where you see private portfolio preference shifts, a euphemism for the risk seeking return mentality that arises from artificially low real fixed income returns and that forces up risk assets. But this can only go one for so long.

See, eventually there will be another recession and the question should be what happens to all those toxic assets on bank balance sheets. What happens if new loans go sour too? If you recall, US FDIC-insured institutions recorded $35 billion in Q1 2012 accounting gains. But the quality of those accounting gains was dubious. Here’s the key line to note:

Lower provisions for loan losses and higher noninterest income were responsible for most of the year-over-year improvement in earnings.

Read it at Credit Writedowns
What record low 10-year rates tell us about the toxic effects of permanent zero
By Edward Harrison

Yields on 10-year Treasuries reached a new record low of 1.617% today.
Regarding the continuing decline, Harrison explains that Long-term interest rates are a series of future short-term rates. The Fed has already “promised” to hold rates near zero through 2014 and I suspect that target date will be extended further by year end. Separately, when the Fed altered policy to begin paying interest-on-reserves (IOR) it also changed the direct measure by which monetary policy is adjusted. Given the enormous size of the Fed’s balance sheet (and outstanding Treasury debt), going forward it may be easier to effectively raise interest rates by hiking the IOR rate rather than actually altering the Fed’s target rate. With these concepts in mind, it should come as no surprise that 10-year (and 30-year) yields continue to move lower in similar fashion to Japan (although I currently don’t expect Treasury rates to reach the JGB lows).

Over the past couple years I have also remained suspect of US banking profits (and by extension S&P 500 operating profits) for the reason highlighted above from the FDIC. Much of the gains appear to be merely accounting profits. When the next recession/crisis hits, those accounting profits can (and probably will) easily flip to large accounting losses. In my view, the risk of serious shortfalls in capital during the next downturn remains extremely present today. As Minsky often pointed out, complacency about risk is often a warning of building risks in the background.  

The next crisis/recession will probably occur with short-term rates still at zero and without many aspects of the Dodd-Frank Act or Basel III provisions in place. Given the public response to previous bailouts, the Treasury/Fed response will be a wild card. Any bets on what their initial actions will be?

Related posts:

Fed Stands in Own Way on Monetary Policy
Treasury Yields Low for Good Reason